The Influence of Independent and Effective Audit Committees on Earnings Quality

Abstract

The Blue Ribbon Committee (BRC) on Improving the Effectiveness of Corporate Audit Committees (1999) argued that audit committees would enhance the financial reporting process, when comprised of members that are independent, financially literate, commit sufficient time to the committee and meet regularly. We investigate whether the BRC recommendations would likely increase the quality of reported earnings by testing whether earnings informativeness and transparency are greater for those firms that currently employ audit committees meeting the BRC recommendations over those that do not. Our proxy for informativeness is the magnitude of the earnings response coefficient (ERC) and for transparency is the degree of mispricing (overpricing) found with accruals. We find stronger ERCs when the audit committee members are independent and financially literate, and less overpricing of accruals when the audit committee members are independent and meet regularly. These results are not sensitive to other factors that could influence the audit committee’s oversight (CEO influence, CEO shareholdings and large outside blockholders) nor to other variables the literature has indicated could influence ERCs or market mispricing. Overall, these results suggest that independent and effective audit committees enhance the quality of reported earnings, lending evidence supporting the BRC recommendations and the Sarbanes-Oxley Act of 2002.